Global economies and financial markets seen from a European perspective

martedì 21 luglio 2009

Inflation/deflation threats hanging over the US economy?

The US consumer price index for June published on Wednesday July 15 has not helped clarify one of the most controversial debates among economists over recent months: the future of inflation in coming quarters and years.

On the one hand, some economists such as John Taylor, a Stanford economics professor, and Marc Faber believe that a sharp rise in inflation could be on the cards mainly because of the expected explosion of public debt in the years ahead. Inflating the economy to ease the heavy burden of a high public debt is also a decision that the US government could take going forward, although this possibility has been dismissed by US Government officials. An increase in the inflation rate above levels that would be accepted under normal conditions is also a solution that some economists have proposed to alleviate the situation in the US. For example, Kenneth Rogoff, a professor of economics at Harvard University, pointed out that a 6% inflation rate would make the high debt burden more sustainable and help deleverage the US economy. John Makin, an economist at the American Enterprise Institute, has recommended the adoption by the Federal Reserve of a target in terms of a price level and not a growth rate of prices.
More difficult to analyse are concerns related to money supply growth. If it is a universally accepted principle that inflation is only a monetary phenomenon, in line with the thinking of Milton Friedman, the evolution of money supply has proved of little use in estimating the trend of inflation, if not for very long horizons, over the last few decades.

Deflationary fears

On the other hand, more reasonable seem to be short-term fears of a fall into deflation due to the similarities between the current economic environment, the US Great Depression in 1929 and the Japanese crisis that began in the1990s.

Some economists, including the 2008 Nobel Laureate Paul Krugman and the head of the World Bank Justin Lin, believe that the current economic weakness is creating a high level of spare capacity, which will likely lead to a further fall in prices going forward.
Under this scenario, and with the process of deleveraging of US consumers far from concluded and the decline in household wealth likely to weigh on private consumption for a long time, it is difficult to envisage that companies could lift prices significantly in coming months. The potential rise in commodity prices could hardly be passed on to end customers.

Deflation fears are being compounded by evidence of the past, which shows that the core CPI index usually continues to decline for several months after the end of a recession.

Nevertheless, the slight drop in the core CPI index in the last few months has led Justin Weidner and John Williams of the San Francisco Fed in their June report "How big is the output gap" to the conclusion that fears of deflation are exaggerated. According to the two economists the current recession could be accompanied by a reduction in the economic growth potential. Therefore, the output gap may be narrower than generally thought (and therefore unemployment will remain high in coming years) and risks of deflation lower.

In spite of the recent heated debate among economists about inflationary prospects, major financial markets have dismissed the threat of a sharp increase either in inflation or deflation. The behaviour of the US bond market bolsters this theory: inflation expectations for the next 10 years have hovered around 1.6% in recent weeks, only slightly lower than the historical average.

But it is one of the most reliable indicators for estimating the trend of inflation in the coming 12 months, gold, to send reassuring signals. Gold is well above the US$900 an ounce threshold, in line with the values recorded in July 2008.

Therefore, the market is not looking for major changes to the inflation outlook. Gold is the variable to look at more carefully to understand the future trend of inflation. After the sharp rebound staged in the period 2001/2008 up to the high of US$1030 an ounce level, which anticipated the surge in inflation to 5.6% in July 2008, gold underwent a downward correction at US700 in September/October 2008 following the Lehman Brothers bankruptcy and now remains steady above the US$900 mark. New precious metal highs will likely show that an increase in inflation in the 12 months ahead is a clear possibility, while a return to the values last seen in September 2008 will provide further evidence that fears of deflation have not been set aside.

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I am an economist with several years of experience in the investment banking field. From 2001 to 2007 I worked at Rasbank (now Allianz Bank) where I covered the US and Eurozone economies, Federal Reserve’s and ECB’s monetary policies. I also provided monthly an international asset allocation for the major international equity and bond markets. From 2007 to early 2009 I was an economist in the European economic team at Dresdner Kleinworth, covering Italian, Scandinavian and Swiss economy.
This brand new blog contains my opinions on global economic developments and financial market trends. I will focus mainly on European economies, though excursuses on the global market places will be frequent. I may have direct or indirect interests in various financial instruments discussed in the blog. The commentary in this blog in no way constitutes a solicitation of business or investment advice.